Why do builders divert buyers funds

Projects delays have been biggest pain point for home buyers across India. Real Estate Developers aka Builders have received lot of bad press in the last several years because of inordinate delays in real estate projects causing heartburns to buyers and investors alike. Unlike in the past when builders were able to “bully” home buyers into silence, builders have lost its “hard power” due to media activism, proactive judiciary, better laws and higher awareness of rights among buyers. So the issue of project delays primarily caused by funds diversion have come into public domain and have become favourite living room discussion. (You may read this article to understand what delays real estate projects in India.)

Reasons for Diversion

So why do builders divert their customers funds? Simply because buyers funds come at no cost i.e. if the builder has to borrow from financial institutions the cost of borrowing varies from 12% to 24% depending upon the usage of funds. Usually they divert funds for following purposes:

Buy new land parcels – This is where most of the funds go. Developers need lands to launch new projects. However cost of borrowing for land acquisition is very high, almost 19% to 24%. So why borrow when the builder can use customers payments to buy lands? Hence cash flows from one project get diverted for some other purpose affecting the project.

Support other projects – Usually all builders will have one or more projects that are drag on their balance sheet due to either poor sales or high capital investment. For example – Commercial & Retail (malls) projects are quite capital intensive in nature and unlike residential projects they do not have regular cash generation by way of sales. Builders divert funds to such projects affecting the cash flow requirement of the project from where funds are being diverted. This is an endless loop & a trap for developers who do not have better cash flow management.

Business diversification – Few builders have diversified into unrelated businesses such as Telecom (Unitech), Cinemas (DLF), Hotels and Manufacturing. Almost all of them have burnt their fingers in these unrelated ventures as these are capital intensive industries which require long break even tenures.

Debt Servicing – Developers borrow funds for construction, operating expenses & land acquisition. Off late there have been a flurry of “Structured Products” offered by NBFCs and PE Funds to developers where these FIs discount cash flows of an ongoing project and give lump sum money to builders. These are high cost funds where cost varies from 16% to 20% per annum. If the sales of the ongoing project slows down, most of the collection from customers go in to servicing the debt, thus leaving little funds for the project construction.

Personal use – Builders usually live a very flashy lifestyle. They drive the most expensive cars & live in the poshest area of their cities. Nothing wrong in it so long these are earned by their own hard earned monies & not from customer advances. There are few builders who have acquired properties in all top cities across the world valued in millions of dollars. No wonder they are getting hammered by the courts in India!

Conclusion

Amongst all reasons for delays, the use of collections from one project into business expansion or construction of other projects or siphoning of funds by real estate developers have been primary causes. Real Estate Regulatory Bill 2016 will reduce this menace (though not end it) as the Act mandates that 70% of customers collections have to be deposited in an escrow account maintained with a scheduled commercial bank. These funds can be accessed by a real estate developer solely for the purpose of construction of the project to which it belongs. The real estate developer can withdraw funds from this account in proportion to stage of work.

PS:- In my 8 years of investment banking experience in real estate I can vouch for the fact that South based real estate developers are much more responsible & transparent compared to their North & West counterparts.

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